Article 6.8 Great Portland strikes with convertible bond
By Ed Hammond
Financial Times September 3, 2013
Great Portland Estates has underscored the strength of demand for London property by issuing one of the lowest-paying convertible bonds in UK history.
On Tuesday, the group, which specialises in developing and owning real estate in London's West End, announced the final terms of £150m-worth of five-year unsecured convertible loan notes, and said the annual interest payment, or coupon, for holders would be 1%. This compares with an average coupon of about 5% for bonds issued by European property companies last year.
Great Portland set the initial conversion price - at which the bonds may be converted into equities - at £7.145 per share, representing a premium of 35% to the average market price of its shares during the bookbuilding.
FT
Source: Hammond, E. (2013) Great Portland strikes with convertible bond, Financial Times, 3 September.
4 Fewer restrictive covenants. The directors have greater operating and financial flexibility than they would with a secured debenture. Investors accept that a convertible is a hybrid between debt and equity finance and do not tend to ask for high-level security (they are usually unsecured and subordinated) or strong restrictions on managerial action or insist on strict financial ratio boundaries. Many Silicon Valley companies with little more than a web portal and a brand have used convertibles because of the absence of a need to provide collateral or stick to asset:borrowing ratios.
5 Underpriced shares. A company that wishes to raise equity finance over the medium term, but judges that the stock market is temporarily underpricing its shares, may turn to convertible bonds. If the firm does perform as the managers expect and the share price rises, the convertible will be exchanged for equity.
6 Cheap way to issue shares.
Managers tend to favour convertibles as an inexpensive way to issue ‘delayed' equity. Equity is raised at a later date without the high costs of rights issues, etc.7 Available finance when straight debt and equity are not available. Some firms locked out of the equity markets (e.g. because of poor recent performance) and the straight debt markets (because of high levels of indebtedness) may still be able to raise money in the convertible market. Rating agencies treat them as part bond, part equity, usually half-and-half,[XVII] thus their issue does not impact leverage levels as much as vanilla debt for assessments such as default ratings, making downgrades less likely.
Note that a bond's conversion price will be adjusted for corporate actions such as share splits (say doubling the number of shares by simply giving existing shareholders one extra share for each one currently held), rights issues (shareholders buying more shares from the firm) and stock dividends (shares issued as an alternative to a cash dividend).
Some variations
A variation on the convertible idea is to have rising conversion prices, e.g. £3 in the first three years, £4 for the next five years, and so on. These are known as step-up convertibles. Obviously, with these the bond converts to fewer shares over time. Another variation is the zero coupon convertible bond, issued at a discount to par value. Going further we can have the zero coupon convertible bond, which is both issued and redeemed at par, i.e. there is no capital gain to make up for the lack of coupons (a par-priced zero coupon convertible). Here the investor is expecting the equity value to rise, but has an element of capital protection through the issuer's promise to repay at par. Yet another possibility is a variable-coupon bond, which can be converted into a fixed-interest rate bond - useful if you can judge when interest rates have reached a peak because you can convert and lock in high interest rates.
The bonds sold may give the right to conversion into shares not of the issuers but of another company held by the issuer. Note that the term exchangeable bond is probably more appropriate in these cases.
Contingent convertible bonds (cocos)
Cocos are convertible bonds which give the investor the right to convert to equity if a pre-specified ‘contingency' occurs, such as the share price exceeding a specified value for a specified amount of time. The coco market really got going in the mid-2000s when a number of, particularly US, companies issued bonds which were convertible into shares only once the share price moved beyond a threshold (set even higher than the strike price for the convertible). This type is known as an upside contingent bond.
Also issued were downside contingent bonds which convert if a low threshold is breached. This downside idea was extended following the financial crisis. Banks needed to raise more reserve capital (the gap between what they owe and what they own) as a buffer against running into difficulties. Banks tend to run with tiny amounts of equity put into the business by the ultimate risk takers, the shareholders. They might put up, say, 3% of the amount that the bank owes to depositors and other creditors. If it loses more than 3% by, say, making bad loans, then it will owe more than its assets, i.e. be insolvent.
The regulators insisted on a programme of gradual beefing-up of equity buffers. Most banks have done this by selling more shares through, say, a rights issue or by retaining more profit in the business rather than paying dividends. However, some bankers thought they did not want to continue increasing the amount of equity capital in the business and looked for alternatives. The main instrument they adopted was the contingent convertible. Some banks opted for the downside contingent bond, which forces the holder to convert to shares automatically if the equity as a percentage of bank assets falls below a pre-determined level (note: the holder has no choice).
This boosts the buffer of capital that will be subject to total loss if the bank has to be liquidated, thus providing greater protection for depositors and other creditors to the bank. In the jargon: it boosted the bank's ‘Tier One capital', reducing the odds of it falling below the regulatory amount. (See Arnold, G. (2014) The Financial Times Guide to Banking for more on bank solvency buffers.)Some banks issued another type of bond to help cope with losses. The total writedown bond (sudden death bond, total loss bond or wipeout coco) is written off completely if the contingency occurs. Thus the bank eliminates a portion of its debts and improves its leverage ratios. This is usually triggered by the equity capital buffers falling below a trigger level approved by the country's financial regulator.
Because of the risks involved of losing the income from the original bond, or losing the amount invested entirely, cocos pay a higher rate of return, up to 8% at a time when interest rates in much of the world are less than 1%, and so hold considerable attraction to investors - see Articles 6.9 and 6.10.